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April 04, 2010

The SEC's New Rule 201 on Short Sales: Taking a Bear Position on Over-Regulation

(Paris, France) – Second thoughts on
first impressions: a revisiting of my early disdain (here) for amended Rule 201 of the U.S. Securities and Exchange Commission
– a new restriction on short selling that imposes an “uptick rule” – a circuit
breaker that would be triggered by a one-day stock price drop of ten percent or
more.

The reflective mood
may itself have been triggered by my vernal equinox relocation to this European
base, for the spring and summer – with possible impact on my publication
schedule, but also a refreshed exposure to perspectives on this side of the
Atlantic.

(At this point, it
would be obligatory for mainstream media to pause for a white-bread definition
of short selling and a summary of the SEC’s rule. Happily in an evolved
environment, all that is needed is this link to the SEC’s releaseof February 24, which in turn leads to Chairman Mary
Schapiro’s speech, and the supporting
staff paper– to all of which the
curious are referred for details.)

I have observed the debate on short sales restrictions to be binary and polarizing – that, as
with handgun control or gay marriage or abortion rights, coherent but
non-negotiable views reside at the ends of the spectrum, with compromising
positions difficult to articulate inside the black-or-white extremes.

Events over the
last two years leave me less sure. On the one hand, it’s hard to generate much
sympathy for the special pleading of John Mack of Morgan Stanley, or of Lehman’s
Dick Fuld before its September 2008 collapse – especially with the recent
release of the Proustian-length exposition by bankruptcy examiner Anton Valukas
(here).

Nor, in pursuit of
honest symmetry, is there any popular sentiment for reining in the pernicious
speculative effects of upside
exuberance. Imagine the vitriol that would be poured on a regulatory rule
imposing a “downtick rule” before buying a stock experiencing a daily uplift of
ten percent.

And yet, even the
ursaphobic are deserving of respect – some days, the bear really does eat you.

Which leads to the
hard and subtle question: how much regulation is the right amount?

And there, I
suggest, the SEC’s “10% price drop” is a filter with much too large a mesh.

As its staff paper
spells out, on an average day from 2001 to 2009, a 10% trigger would have hit
some 4% of covered securities – and nailed some 1.3% even during an interim
period of supposed low volatility.

For a sympathetic
but skeptical observer, government interference at the two-sigma level is just
way too much.

Not least, the
administrative burdens on both market participants and the regulatory agencies
themselves will be enormous, yet with no more than SEC's repeated say-so on the benefits to broad-based
legitimate activity, while consuming energy and resources better deployed to
the real problem cases.

Many examples demonstrate
that where a sector’s violations emerge from a very small part of the
population, enforcement efforts that are imposed universally achieve only massive
waste and minimal effect -- where targeted programs would be more effective at
far less cost and disruption:

Most
modern automobiles are essentially clean and non-polluting; the bulk of vehicle
emissions come from a very small number of “dirty” cars and trucks – which can
be effectively identified by mobile, low-cost “drive-by” monitors rather than
broad and expensive inspection programs.

Recall
the Clinton-era imposition on personal charitable donations, requiring useless acknowledgement letters that have done nothing but stuff files and eat
up time, paper and postage while adding no benefit to IRS tax enforcement.

Transportation
“security” in the post – 9/11 era has reduced the effectiveness and civility of
air and rail travel at every level, all to the anxiety and unease of the general
public -- but at the imposition of full body pat-downs and loss of gels and toothpastes,
has failed to identify dangerous shoes and underwear – when contrasted with the
nearly-invisible (and when well-used) highly-focused intelligence.

And closest to the
subject, as I asked recently (here), what good has been accomplished by all the
expenditure of corporate and agency time and budgets required under the Sarbanes/Oxley
law – ostensibly functional for six full years as of the undeterred collapse of
Lehman Brothers and the worldwide financial markets oscillations that followed?

Recent research brings
forth the learning that the causal factors for the types of problems cited
above are not uniformly spread through a population, but cluster within a small
sub-set of the whole – a proposition that calls for dramatic re-engineering of
law enforcement and regulatory policy.

A good place to
start would be with short-sale limits calibrated to the really impactful – not
4% per average day, but perhaps 4% per year
– situations that would be recognizably dramatic, readily identifiable and
agreed as worth attention on a consensus basis, while generally leaving alone
both the markets’ longs and shorts.

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